Debt is an inevitability for many living in the developed world. On the one hand, a large consumer economy for goods and services fans the flames of debt when consumers get carried away. This is a very unhealthy form of debt for the individual, who ends up paying even more for depreciating goods that will often turn obsolete, simply out of desire to have something. For those that end up taking on debt to afford necessities like groceries, the unfortunate cycle becomes one of paying extremely high interest rates just to get by on an insufficient income, making it harder to save and get ahead.
On the other hand, debt can come from taking advantage of an opportunity or appreciating necessity. This basically covers taking out loans to invest (in businesses, stocks, or otherwise), gain post-secondary education, or buy a house. The end result of each of these loans is something that can create wealth within a greater economy and for the individual taking out the loan. Just from this comparison, it is clear that not all debt is bad, and it is ultimately a necessary tool in society that allows people to pursue a reward based on calculated (or assumed) risks.
It may not always be obvious, but when most take on student loans to enroll at a post secondary institution to pursue a certain diploma or degree, they are taking a risk that whatever field of study they are going into will give them some future opportunity to live while practicing in that field (in most cases). When you buy a house, you are taking a risk that the city/county you are going to be living in will continue to invest in infrastructure to service your house and you will have access to all of the amenities, businesses and services the locale has to offer. This supports increasing property value as well as the quality of life you have in that neighborhood.
Although relatively uncommon in countries with growing populations, you'll see that cities that have had major population declines have suffered in terms of house price, like Detroit, MI. Detroit's population was over 1 million just over 30 years ago but has since fallen to 672,000. That's equivalent to a third of your neighbours just getting up and leaving! House prices fell dramatically in the same period, from a high of $80K in 2008 to a low of just under $30K in 2012. Meanwhile, the city itself declared bankruptcy in 2011 as tax revenues lagged the costs of providing city services and areas of the city continued to fall into disrepair.
When it comes to business, whether it be investing in your family-run business, buying publicly-traded stocks or a corporation creating a new product line, the need for capital is universal. It's why a situation such as a credit crunch has the potential to severely stall an economy. Without access to lenders, borrowers would have a hard time expanding operations for their businesses. And with limited ability to expand operations, the society as a whole would have greatly hindered economic growth, reducing the future wealth prospects of everyone in that society.
With these positives and negatives of debt in mind, we can take a look at one's individual financial picture to maximize the benefit of debt.
Debt can primarily be ranked based on the cost of servicing it. The service cost is tied to the interest rate of that debt. Using credit cards as an example, interest rates typically hover around 19.99% a year, with some reaching as high as 29.99% a year (department store credit cards). With such an extraordinarily high interest rate, this debt sits close to the top of the food chain when it comes to what you want to focus on paying down first. Payday loans manage to blow all other categories out of the water due to their short-term repayment schedule and high fees (in percentage terms).
This list gives you a top-to-bottom list of what debt you should tackle first:
- Payday loan - 200% - 600%
- Credit card debt - 19.99% - 29.99%
- Line of credit - 4.70% - 10.00%*
- Student loan (if you have graduated) - 5.20% - 7.70%*
- Home equity line of credit (HELOC) - 2.70% - 5.00%*
- Mortgage - 2.00% - 4.00%*
- Student loan (if you have not graduated) - 0.00%*
*Note that the above rates are based on the current prime interest rate of 2.70%, set by the Bank of Canada. When interest rates go up, as they eventually will, the cost of debt that is based on the prime interest rate will go up as well, although the rankings will largely remain the same.
Of course, the above list is not exhaustive, as there are a variety of loan types for specific uses that are not covered, but it covers the most common types of loans that you will encounter. The time that you borrow, your credit score, annual income and assets will all have a potential impact on what rate you pay. The above interest rates are given as a guideline that will fit the majority, but in the event that your interest rates are not in the same heirarchy, you would simply rank your debts from highest to lowest interest rate.
You can see the absurdity of the interest rate on payday loans and credit cards. As such, you should be targetting to carry absolutely no debt through either of them. Stay away from money marts and pay your full credit card balance every month, and you'll be fine. After that, you can chip away at each of the next highest-ranked debt, knowing you are minimizing the total interest rate you pay as much as you can be. You'll also notice that the debt that provides some opportunity will typically be close to the bottom of the list (student loans and mortgages).
If you are savvy when it comes to personal financial management, it is possible to strategically use promotional (temporary) rates to adjust your debt rankings and minimize the total amount of interest you are paying for all your debt, although most will not have this opportunity, and it would only benefit marginally over a shorter timeframe.
Take an inventory of all your outstanding debt, and see how yours rank!